Kiddie Tax: New Hazards, New Opportunities

Despite its name, the kiddie tax is far from child's play. As a result of the Tax Cuts and Jobs Act (TCJA), children with unearned income may find themselves in a higher tax bracket than their parents. At the same time, the TCJA also creates new opportunities for family income shifting.

Income shifting discouraged

At one time, parents could substantially reduce their families' tax bills by transferring investments or other income-producing assets to their children in lower tax brackets. To discourage this strategy, Congress established the kiddie tax in 1986. The tax essentially eliminated the advantages of income shifting by taxing all but a small portion of a child's unearned income at his or her parents' marginal rate.

When the kiddie tax was first enacted, it applied only to children under 14, but in 2007 Congress raised the age threshold to 19 (24 for full-time students). Note that the kiddie tax does not apply to children who reach 19 (or 24, if applicable) by the last day of the tax year. In addition, the tax does not apply to children who either 1) are married and file joint returns, or 2) are 18 or older and have earned income that exceeds half of their living expenses.

Tax bite bigger

Starting in 2018, the kiddie tax applies according to the tax brackets for trusts and estates, rather than the parents' marginal rate. In previous years, the kiddie tax essentially undid the benefits of shifting investment income to one's children. By applying the parents' marginal rate to that income, the tax result was about the same as if the parents had retained ownership of the assets. But, the TCJA's approach can push children into a higher tax bracket before their parents in many cases. That is because the highest marginal tax rate for trusts and estates — currently, 37% — kicks in when taxable income exceeds $12,500. For individuals, that rate does not apply until taxable income reaches $500,000 ($600,000 for joint filers).

Suppose that a married couple filing jointly has taxable income of $250,000 per year, placing them in the 24% tax bracket. If they transfer investments generating $30,000 in ordinary taxable income to their 17-year-old daughter, she is taxed as follows:

Assuming she has no earned income, the first $1,050 is tax-free and the next $1,050 is taxed according to the regular individual income tax rate (10%, for a tax of $105). The remaining $27,900 is taxed at the rates for trusts and estates. In 2018, that means the first...

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